The Ugly Surprise Awaiting Uninformed Bond Investors

The Los Angeles Times, May 5, 2004 (Kathy Kristoff)

Ignorance and interest rates could prove a disastrous combination for investors who have money in the bond market. Investment professionals are predicting that interest rates will start to climb this year, and that’s something that can slam bond values – no matter whether the bonds are issued by the government or corporations. But few investors seem to understand the connection, industry experts contend.

“Investors hear ‘bonds’ and they think ‘safety,’ and that’s a terrible fallacy, especially when interest rates start to rise,” said Andrew Stoltmann, a Chicago-based securities attorney with Maddox Hargett & Caruso. “Bonds are one of the least-understood investments around.”

Indeed, recent surveys found widespread confusion about the relationship between interest rates and bond prices. The National Assn. of Securities Dealers surveyed more than 1,000 investors last year and found that 6 of 10 didn’t understand that bond prices fall when interest rates rise. By the same margin, investors didn’t understand that long-term bonds are more volatile than shorter-term bonds.

In a survey in January of 400 investors conducted by Kansas City, Mo.-based American Century Investments, 1 of 4 investors interviewed believed that bond prices rose when interest rates rose. There is also confusion over volatility. The American Century poll found that 4 of 10 investors believed that the longer the bond’s maturity, the less sensitive its price was to interest rate swings.

“It is important that investors understand what rising interest rates might mean to their portfolio,” said Dave MacEwen, senior vice president and chief investment officer of fixed income at American Century Investments. The NASD sent a notice to brokers last month, reminding them to better explain bond risks to customers. Bond-related complaints filed with NASD for arbitration have nearly doubled in the last two years.

“Given that interest rates are likely to rise from their current and historically low rate, NASD believes that it is imperative that investors understand the various risks, as well as the rewards, associated with debt securities,” the notice said.

Things to Know

What do bond investors need to know? First, they should be aware that interest rates and bond values almost always move in opposite directions. When interest rates fall sharply, the value of previously issued bonds can soar. That’s because the interest rate paid on those old bonds is likely to be higher than investors could get in the open market, causing the old bond to sell at a premium.

Likewise, when rates rise, the values of previously issued – and now, relatively low-paying bonds – can plunge. The percentage drop will depend on the type of bond – corporate or government, high-quality or high-yield – and the maturity date. But it’s safe to say that the loss on a long-term bond – one with a maturity that is 10 years or more away, will be many times the loss on a bond that matures in a year or two. That’s because, with a longer-term bond, the investor will be stuck with a comparatively low-paying investment for a longer stretch.

The moral of this story: In a rising-rate environment, investors are wise to keep bond maturities short. For example, MacEwen noted that when the price of 10-year Treasury bonds fell 5.5%, his company’s two-year Treasury portfolio was off just 1%.

Only one type of bond sometimes does better as interest rates rise, MacEwen added. That’s high-yield or so-called junk bonds. The reason these can appreciate even as interest rates rise is that climbing rates are usually a sign of a strengthening economy, which can help the financial health of the highly indebted companies that issue junk bonds. That can improve the credit quality of the issuer and make the bond more attractive.

Investors should also know how to buy bonds. There are two basic ways: individually or through a mutual fund. Mutual funds can provide broad diversification, potentially reducing the bond owner’s default risk. But they can also pose significant risks of their own, Stoltmann noted.

When interest rates rose sharply in 1994, for example, one short-term government bond fund lost 40% of its value virtually overnight. The reason: The fund used derivative securities to boost its returns. Derivatives – such as contracts to buy more bonds at a particular price in the future – can magnify returns when the market goes the right way, but they can decimate a portfolio if the owner is forced to buy securities at a loss. The value of those derivatives crashed when rates went up, shocking individuals who believed they were investing in a pool of conservative, short-term bonds.

“I will virtually guarantee you that when interest rates go up, as we know they are going to do, we will see a number of bond funds explode like that,” Stoltmann said. It’s imperative to read the prospectus when investing through mutual funds, he added, and pay particular attention to the types of investments the fund buys and the section titled “risks.”

Some investors believe that interest rates affect bond funds more than individual bonds because bond funds disclose their net asset values – the value of all the investments in the portfolio, divided by the number of shares – daily, making investors well aware of price swings. Buyers of individual bonds, meanwhile, are rarely reminded of the price they would get for their bonds if they sold today.

However, if the underlying investments are the same, the interest rate risk is equivalent – even if it’s not as transparent. Anyone who sells a bond before its maturity date faces a risk of loss. Does the fact that bond managers are more likely to trade securities make the bond fund riskier than individual bonds? Not necessarily.

If a bond manager sells bonds in a rising-rate environment, he will probably reinvest the proceeds at a higher return, making the transaction relatively equivalent from the standpoint of a long-term investor.

The one caveat: If a large number of investors pulls their money out of a bond fund, the manager will have to sell bonds at a loss and won’t have proceeds to reinvest at a higher return. In this instance, the remaining bond fund investors will be comparatively worse off.

The cost of investing in a bond fund can be determined by anyone willing to navigate the prospectus for the fee disclosure section, Stoltmann said.

Broker Compensation

For individual bond purchases, brokers are compensated either by a commission, which is typically disclosed, or by means of a markup in the price of a bond, which often is not disclosed. The markup can be substantial, particularly with lower-quality bonds, Stoltmann added. For example, a brokerage firm may have purchased a $1,000 bond for $950 because its yield is under-market, and then resell it for $1,000. The $50 (or 5.3%) markup is far more than what an investor would typically pay when buying a similar amount in stocks. Junk bonds often sell with markups of 10% or more, Stoltmann said.

The only thing that’s certain is that the broker is compensated one way or another. The NASD stresses that brokers should make this clear. Stoltmann maintains that they often don’t – and that investors should consider this a red flag. “Some brokers will tell a client that a bond is trading commission-free,” Stoltmann said. “Technically they are correct, but they are trading with a markup, which is the equivalent of a commission.”

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